As automotive suppliers begin work on their 2018 tax returns and implement plans for their capital expenditures in 2019, suppliers should look at a potential tax credit to help offset the costs of tooling: the Research and Development Tax Credit under section 41 of the Internal Revenue Code (the R&D Credit). While the IRS has typically taken a tough stance on challenging tooling costs as eligible expenses, recent cases indicate that the IRS may be shifting to a more taxpayer-friendly position. Also, hopes for an Alabama R&D credit have been revived, as we discuss below.
The R&D Credit is generally available for “qualified research expenses” incurred by a business, subject to certain restrictions. For automotive suppliers with large tooling costs, the treatment of tooling costs as “qualified research expenses” may result in a large R&D credit to significantly offset the company’s expenditures. Among other requirements, two facts-and-circumstances tests must be met in order for tooling costs to be “qualified research expenses.” The first test is that the taxpayer must bear the economic risk that the tooling will perform adequately, and many tooling costs will easily meet this requirement. The second test is that the taxpayer must transfer ownership of the tool to its customer (i.e., the property cannot be subject to depreciation by the taxpayer).
The IRS has a history of challenging the eligibility of tooling costs as qualified research expenses based upon this second test. Automotive suppliers received a glimmer of hope in late 2018, as the IRS conceded its Tax Court case against TSK of America Inc., in which the IRS initially challenged the supplier’s R&D credits for its specially-designed tooling. By conceding the case (after discovery and the filing of expert reports), the IRS may have shown a willingness to allow credits for tooling costs where the facts show that the expenses meet both tests described above. A Tax Court petition involving similar facts has been filed by Shiloh Industries Inc., challenging the IRS’ disallowance of $24.5 million in tooling expenses as qualified research expenses (Docket No. 20802-18). Automotive suppliers, and their tax advisors, will be closely following this new Tax Court case to see if the IRS’ position in TSK of America represents a fundamental shift that would resolve the uncertainty surrounding the availability of R&D credits for automotive suppliers. In the meantime, suppliers should re-examine their expenses to make sure that they are capturing the total value of the lucrative credit.
A draft of Alabama R&D tax credit legislation is being circulated among potential supporters in the Alabama Legislature and in the business and biotech communities. Similar to previous versions, the current draft would grant an income tax or financial institution excise tax credit to companies doing business in Alabama if the R&D was performed in the state and was conducted either by the company itself or by a third party. In the latter case, an additional incentive would be available if the research entity is an accredited university or qualified Alabama research entity. Like IRC section 41, the credit would be granted only for incremental R&D expenditures, looking back over a three-year test period, and limited both in terms of what each taxpayer-applicant can claim and what all taxpayer-applicants can claim during a given calendar year. The draft legislation has been endorsed by the Birmingham Business Alliance, the Montgomery Area Chamber of Commerce, and the West Alabama Chamber of Commerce, to name a few of the likely supporters.